The market crash during the Financial Crisis in 2008-2009 increased the level of uncertainty in the markets dramatically, and generated significant anxiety and financial losses for a wide spectrum of market participants. The severity of the stock market crash and the speed of the retracement highlight the effect of certain common behavioral traits and tendencies that caused many investors to take losses at the height of the crisis and subsequently underperform the market rally. Similar loss aversion behavior is observed amongst institutional investors causing trading patterns that aggressively reduce risk following losses and mildly increase risk following gains. These observations suggest that there is a need for new financial instruments to alleviate the anxiety of market participants during market turmoil, and which are transparent and easy to manage.
There are many products and financial instruments that offer different characteristics during a market sell-off. These range from specialized bear-market funds, structured products effectively providing market level stops, traditional options strategies used as insurance, inverse and leveraged inverse Exchange Traded Funds (ETF), to various volatility related products like variance swaps, VIX futures and associated Exchange Traded Notes (ETN). Common to these strategies is the suggestion that the performance of these instruments, when they are employed or triggered, exhibit substantial negative correlation to the markets contemporaneously. For example, both retail and institutional investors have been attracted to VIX-related products due largely to the statistically negative correlation to market returns.
Employing products that rely on a strong negative correlation to the market as a hedge for a long market portfolio is equivalent to an attempt to short the market. The timing of the use of such products as insurance against a market sell-off is the same problem facing market participants deciding when to reduce or to sell off their long market exposure, and when to buy to establish their long market exposure again. As it is observed previously, this exercise has led to losses due to common human psychology.
The recent growth in awareness and interest in volatility products like the VIX futures and associated ETFs/ETNs have popularized the use of levels of VIX, as a proxy of implied market forward volatility, to be an indication of market anxiety. The concept of the VIX and the volatility measure it represents is complex, and in popular usage, the actual VIX index levels are often compared against historical VIX levels in commentaries about expected market behavior; it is rare for commentaries to refer to the exact meaning of VIX and how it relates to expectations of the impact of market events. The VIX index is calculated using listed options quotes across a wide range of strikes over two front month option expiration terms. In markets without a deep and liquid listed options market, indices like the VIX can be unstable due to wide quotes, and the price discovery process is less effective with lower options market liquidity. In emerging markets without a listed options market, it would be impossible to define a VIX-like index. In more developed markets, liquidity in options market could be reduced significantly, and quotes across wide ranges of strikes could be unreliable and very wide during periods of extreme market stress and dislocations; this could affect the quality of the calculation of the VIX index and the settlement of financial derivatives based on the VIX index could be affected dramatically.
The VIX futures represent the exposure of a risk factor that is equivalent to the market's expectation of future level of market activity commonly expressed as implied volatility. Note that the VIX and VIX futures are rolling forward expectations of market volatility; there is no mechanism to explicitly reward users of the product if the anticipated level of market activity actually occurred, except to sell the futures after the event, relying on market expectation of autocorrelation of volatility. The market re-prices risks and implied volatility very quickly after an event. The mechanism to benefit from actual market activity is known as realized volatility. Realized volatility, in contrast to future implied volatility, is defined by measures dependent on actual market movements during a historical period.
Standard options such as put and call options, or other products offering some contingency payoffs, provide a certain level of insurance against a market sell-off for the price of the option premium. For most non-professional market participants, the use of these contingent payoff products as insurance could incur expensive premium outlay over the long run. In addition, expiration cycles and contract specification details are complications that could deter many market participants. These products include exposure to implied volatility and directional insurance. As with all insurance products, the premium is not recoverable if the contingent payoff is not triggered by the actual event. Although the price of options take into account of future implied volatility, actual realized volatility is not compensated without additional active hedging.
Markets could gyrate violently over a period and end up at the same level. This happened many times in recent years with examples like the Bear Stearns collapse in 2008, Flash Crash in 2010, Japanese tsunami and nuclear incident in 2011, and S&P US Downgrade in 2011. For example, over a 2 month period, February 2011 to end of March 2011, bracketing the Japanese tsunami and nuclear incident in Fukushima, the market re-priced implied volatility as the market levels recover from a relatively quick sell-off to end with market levels and VIX levels relatively unchanged. A put option position, without dynamic hedging, held over this period would not have generated any profits if it is not sold at the height of the crisis to take advantage of the dramatic increase in volatility and drop in market level.
Variance swap or variance futures contracts may be useful to generate returns based on actual realized volatility from market gyrations over a fixed period without betting on the direction of the market moves. These contracts are defined to generate payoffs from functions of average squared observed returns. However, the standard variance swap contracts specifications involving calculations for volatility from squared returns is not intuitive to an average market participant, and even professionals are often confused when translating expected market movements from volatility measures. It is hard for an average person to relate his expectation of daily movements measured in returns to a square root of average squared future expected returns. Although the concept of variance is a mathematical measure used in standard option pricing methodology, it is not clear that the general population of market participants is aware of the potential disconnect between the expectation of average large moves in the market to a measure that is dependent on the actual distribution of the large moves.
There is a theoretical method of variance swap static replication using a continuum of standard options. In practice, perfect replication is not possible and subject to truncation that can lead to potentially large losses in a dramatic market crash. This is a real and significant problem in markets without sufficient options liquidity to construct the replicating options portfolio. Indeed, this has happened during the recent 2008 market crash causing significant losses to sellers of variance swaps due to the significant convexity in the payoff. Increasingly, variance swap contracts are traded with caps on maximum variance and this translates to a problem with pricing the value of this cap as an option on variance; this then invalidates the attraction of a simple theoretical static replication. Another development is the adoption of volatility swap that defines a payoff on the square root of variance; in doing so, there is no longer a static replication using standard listed options, and the problem with the non-intuitive definition of volatility still exists. The theory behind the management of volatility swap requires the dynamic management of the hedging options portfolio.